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Investing in the stock market: why you can and should ditch your money manager today
Why you should invest in the stock market
Once upon a time, there was a concept called "interest" that applied to checking and savings accounts held at banks. This meant that your money made money, just sitting there. Ask your grandparents about it, I'm sure they'll remember it fondly.
Nowadays, holding your assets in a bank actually costs you money via monthly and random discretionary fees, which is not great if you like to be alive and buy things.
Furthermore, there is this thing called inflation that effectively makes your money worth less the longer you let it sit there. The idea here is that over time things cost more money, so your money is worth less; at a rate of about 4% per year.
This all sounds bad, but there is absolutely something you can do about it. Enter the stock market. Historically, securities on average have enjoyed a return of around 10% in the 20th century. This means a wealth increase of 6%, adjusting for inflation.
I don't remember who said more money more problems, but that individual is mistaken. Investing in the stock market is one step you can take to combat this blatant ignorance.
What do stock brokers actually do?
Most of their job is convincing you that they know what they are doing. Money managers get paid when you invest and make transactions, so they have less incentive to actually make good decisions, and are more likely to push fancy, newfangled products into your face. This is where we get in trouble with CDO's and other ill-founded concepts that led to the global financial collapse in 2008.
The other part of their job is redefining what your actual return is and glazing over the fact they are skimming profits left and right by way of transaction fees, management fees, performance fees, and the seldom understood but highly costly 12b-1 fees.
There are some managers that actively try to make their clients money by over-analyzing accounts and frantically re-balancing holdings, but these efforts all too frequently result in exacerbated, and hidden costs that will be discussed further.
Can stock brokers earn you a higher return?
The simple truth is that there is no evidence to suggest that money managers can consistently beat the market. So much research has been done on the subject I am shocked that the internet isn't full yet.
You might be saying: now wait just a second young lad, my manager claims to have beaten the S&P 500 for ten years consecutively, and I trust him. Well, there is a perfectly reasonable explanation, even if his claims are not fictitious, and the answer lies predictably in statistics.
Just like pretty much everything, the performance of different stock brokers follows a normal distribution. Some get lucky, and some fall short, but most fall in the middle. The interesting thing, albeit admittedly obvious, is that the mean of managers' returns falls on the mean of the market in aggregate.
While there are some managers that beat the market seemingly consistently, this is expected according to fundamental statistics. This does not mean that they will beat the market in the future, just like flipping heads 10 times in a row does not affect the odds on the 11th toss. Luck is not an inherent characteristic of any entity, it is a social construct used to justify humanity's ignorance of statistics.
In short, if you believe basic mathematics, you shouldn't believe your money manager. You could literally throw darts at a newspaper to pick stocks and outperform most managers after fees are taken into consideration. I know this because we did that experiment in FIN 651 with professor Stefano Gubellini.
How much are they charging for this?
We have talked a little bit about the different types of fees, enough to know that there are a lot of them, and to hint at the fact that they add up quickly. I believe a detailed discussion about their exact methods of skimming off of the top is better left to an entirely separate article. For now, let it suffice to say that they are profoundly varying and convoluted in practice.
What you need to know is how this affects your bottom line. Current research suggests that an accurate reduction in profits is around 40%. That means that for every dollar the market returns, you are giving away 40 cents and keeping 60. Knowing that managers struggle to beat the market will hopefully aid in setting this phenomenon in perspective.
The good news is, you totally don't have to submit to this unjust treatment.
How can I get around money managers' fees?
If you really trust your adviser's intuition, despite everything I have told you so far, there is a relatively simple way to copy, or shadow, their portfolio. For legal reasons, financial institutions are required to publish what is called a Form 10-K, which is publicly available in the EDGAR database found at the link below or by searching "edgar" in Google.
Once you find the firm's prospectus, simply look up what securities they are holding and in what relative percentages. You may be lagging a bit in the sense that the 8-K and 10-K documents are filed only quarterly and annually, but in all likelihood you will far surpass their performance when fees are taken out of the equation.
Did you click on that link to check out some 10-Ks?
Is a diversified portfolio really that important?
That depends on your priorities as an investor. More accurately, it depends on your relationship with risk. Most people are described as being risk-averse, meaning that they value a safe gamble with a lower return more than a risky venture with more at stake. A semi-accurate rule of thumb: if you do not have a chronic gambling problem, you are probably risk-averse.
A popular system among novice investors is to pick a few companies that they like and invest way too much of their portfolio in them. The problem with this is the stocks they pick likely have too much co-variance, i.e. too much in common. Simply put, if one stock under-performs, the rest of your portfolio probably will too. This is bad for risk, and in turn the risk-averse investor. Diversifying your portfolio is the solution.
An analogous situation would be as follows: you could randomly throw darts (single stocks), or just take the whole dartboard (diversification). Throwing all bullseyes would grant a higher return, but you also run the risk of missing the board entirely.
What are the best stocks to invest in?
Assuming risk-aversion, the typical investor should strive to maximize an equation known as the Sharpe Ratio. Simply put, you want the highest return for the lowest risk. This sounds straightforward, but the unpredictability of the market can make choosing securities with consistently high ratios a nightmare in practice. Again, diversification is your friend here.
What people normally associate with diversification is holding a lot of different stocks. This is good practice, because the law of large numbers is on your side, but the real problem is co-variance. If you have 20 stocks that all follow each other, it is not much different than just holding one stock.
What good diversification means is minimizing co-variance. You can do this by strategically holding stocks that differ in return profiles, but the easier route is to hold thousands of stocks that vary across industries, capitalization, and other key metrics.
Fortunately there are classes of securities that do this for you. Chief among them are index funds and exchange traded funds (ETFs). What these positions do is attempt to mirror an entire asset class such as the S&P 500. The great thing is that they get roughly the same rate of return as the market for a fraction of the cost of money managers.
What are ETFs?
I'm ready, where do I start?
There are plenty of resources for investing online. You can check out TD Ameritrade, Scottrade, TradeKing, eTrade, OptionsHouse, and TradeMonster just to name a few. The super important thing here is to wait and take advantage of the promotions that these companies offer constantly. Read the fee structure intensively for any red flags.
If you visit all of these sites right now, there is probably at least a few of them that have an active promotion that gives you 100 free trades and no monthly fees. This will save you a bunch of money in transaction and management fees, which will help your bottom line.
You can also usually find a list of commission-free ETFs on many online brokers' websites. Utilize these lists when selecting your assets to minimize fees and further bolster your returns.
Please note that investing is by its very nature risky, before you go all gangbusters, please read the advisory notices that follow.
Here is a great database for online brokers I found
- The Best Online Brokers for Stock Trading - NerdWallet
NerdWallet reviews the overall best online brokers for trading stocks, day trading, deep discount brokers, and commission-free ETF trading.
Investor Mistakes: attempting to time the market
You might have noticed that the stock market seems to be very chaotic. This is a very astute observation, and has distinct implications for how you should manage your portfolio. The price of securities follow what finance gurus call a "random walk." This phenomenon is highly persistent in nature and can befuddle what would otherwise be a savvy investor.
A random walk is exactly what it sounds like. The immediate future of a stock's value is inherently unknown. Anyone claiming to have knowledge otherwise are either lying to you, or have access to highly illegal insider information. The latter of which would not be shared with you, since there is no reason for them to disclose such a lucrative tip, so my bet is that he/she is blowing wind up your skirt.
The two main tenants of this misconception are as follows:
1) This stock's price keeps going up, its probably going to keep going up, buy now!
2) This stock's price just plummeted, it's probably going to recover soon, buy now!
Obviously, these two arguments are mutually exclusive. Since neither have been either consistently proved or disproved, the logical conclusion is to reject both premises. In short, do not allow yourself to be deluded into thinking you can time the market.
Investor Mistake: trading frequently.
At this point, you have realized the prohibitively high cost structure of traditional managers, and have opted to do it on your own. Congratulations, but don't get too hasty just yet. The whole point of investing on your own is to circumvent transaction and management fees. This effort will be altogether thwarted if you get all excited and start flipping stocks left and right. There are numerous costs associated with stock transactions, and none of which add any real value to your investment.
The hyper vigilance of an overly active investor can quickly cut into his/her profits. This is a practice known as "day trading", and is better left to those with inside information and sophisticated computer algorithms. These entities are much more adept at sniffing out market fluctuations and pricing arbitrage. If you don't recognize the term arbitrage, you're probably better off picking some well diversified ETFs and letting them distill in peace.
Furthermore, if you're the type of person that wants to give their money to a stockbroker and just let them work their "magic," then day trading probably isn't for you (not that I would suggest it in the first place).
Investor Mistake: believing the hype
This happens way too frequently, a company like Apple issues an IPO, and everyone just loses it. Don't fall prey to this phenomenon. What happens is a lot of people get all excited and drive the price superficially high, then once the excitement subsides it takes your money with it.
Some people might want to take advantage of this and short the option, which is totally a potentially lucrative move if you are able to play off the market arbitrage, but I would warn you to remember the unpredictable volatility of the market. If anything, do the opposite of what is popular, but keep in mind the nature of the random walk.
To summarize this rather lengthy dissertation, here are a few key points. First, you should definitely be investing in the stock market if you want to trade a small amount of risk for a higher (or even positive) return on your money. Next, do not trust a money manager. They will cost you way too much money. Lastly, using this guide, you have every ability to start investing on your own successfully. You will probably even beat your old stock broker.
© 2015 Luke M. Simmons